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The Corporatization of Law

In 2007, Australia’s Slater & Gordon was the first law firm to go public. Jonathan Molot, a law professor at Georgetown and a co-founder and CIO of Burford Capital, argues that this should become the rule, rather than the exception. In his Southern California Law Review article, What’s Wrong with Law Firms? A Corporate Finance Solution to Law Firm Short-Termism, he states that law firms are too focused on short-term revenue instead of long-term gain. This “short-termism” results in high employee turnover, low morale, limited work-life balance, and client dissatisfaction. Molot credits the traditional law firm partnership model as the source of short-termism.

According to Molot, one flaw in the traditional partnership model is that a partner’s equity interest disappears once the partner no longer works at the firm. This impacts the goals and expectations of each partner and the timeframe for which they measure success of the firm. This disinclines partners from postponing gratification by investing in the future. Molot considers this an outdated ownership model. “The changes that have transpired in law practice have rendered the old model of law firm ownership not only obsolete, but harmful.”

Within corporations, permanent equity holders tie the interests of management with the interests of other stakeholders. In a traditional law firm model, different stakeholders have divergent interests. “The law firm fails to maximize long-term profitability when it fails to satisfy client demands for fixed-fee billing; when it fires associates or turns down partnership candidates during lean times even though those lawyers would contribute value over their careers; and when it forces productive partners into retirement so as to free up profits to distribute to the rest of the partnership.”

Molot makes two basic claims. First, law firms are not inherently different than other businesses that provide professional services and, second, law firms should, therefore, operate as corporations with a traditional corporate capital structure. Molot argues that not only would this change in law firm structure alleviate the previously mentioned flaws in the current structure, but it would allow firms to leverage debt or equity to finance growth. Unsurprisingly, professional regulation in the US is the largest roadblock to a future looking business model. Regulatory reform of RPC 5.4, which precludes non-lawyer ownership or investment in law firms, would have to be revised to realize Molot’s hypothesis.

Molot states that “England, Australia, and the District of Columbia are moving in the right direction, and that professional norms can be respected by lawyers practicing in the context of a traditional corporate form. Professional concerns cannot justify the retention of an inefficient, costly organizational structure.” In the US, the bar often argues that a move to non-lawyer ownership or investment in law firms would result in a reduction in lawyer ethics. However, Molot counters that “[t]here is no evidence that outside ownership of law firms in any of these jurisdictions has had any deleterious consequences.”

Others in the bar complain that the profession is already too much like a business. Molot addresses this point by stating, “I suggest that the problem with law firms— and a root cause of lawyer and client dissatisfaction—is not that law firms are run as businesses, but rather that many of them are poorly run as businesses.” “Rather than simply accepting (and perhaps lamenting) that law has moved from being a profession to being a business, law firms should strive to be better businesses.”

Molot’s solution to short-termism is to provide permanent equity in the law firm to stakeholders. “The obvious solution to this problem is to align the interests of managers with those of the company’s long-term stockholders through stock grants or options that vest over time and cannot be sold for an extended period.” “[P]ermanent equity can encourage law firm partners to adopt a longer-term perspective and become more attuned to the best interests of junior lawyers and clients.” “Permanent equity tends to have a similar effect by rendering firm success more important to a lawyer’s personal wealth than personal success.”

Molot goes further than simply suggesting a modification in employment practices. He firmly believes investment by non-lawyer stakeholders is critical for long-term success of law firms and the sustainability of a corporate business model. “It is a basic fact in finance literature that there is a liquidity premium for easily saleable, publicly traded securities, and an illiquidity discount for closely held companies whose stock is not saleable.” “If we restrict law firm equity to the firm’s current and former employees, we retain a core part of the problem we started with: we make the mistake of putting investment decisions in the hands of individuals who must affirmatively decide to sacrifice current compensation in favor of long-term goals.”

In conclusion, Molot argues that “[a] revised structure would give all of a firm’s constituencies what they so badly crave: a law firm focused on long-term, value-added relationships rather than hourly fees and current billings.”

Molot’s article is certainly worth the read, but I doubt that existing law firms will modify their structure as he suggests. Corporatization will happen through the course of consolidation after liberalization of the ethics rules occurs. Under present regulatory conditions, the kind of corporatization suggested would represent a complete disruption of the current, traditional law firm business model. That disruption would significantly weaken the short-term interests of current partners who would be left with little or no certainty that the long-term benefit of doing so would materialize. Rather, partners will likely want to be bought out rather than undergo some kind of voluntary de-equitization and subsequent redistribution of ownership and/or profit sharing interests. Additionally, I don’t think it is a given that hourly billing will completely go away even if law firms are corporatized. Yet, I would expect far greater innovation in client service delivery and pricing.